Tapping the equity in your home with a home equity loan can help you get a lower interest rate than an unsecured loan, and it can also earn you an income tax deduction. The deduction does not impose any income limits, so you don't have to worry about losing the deduction if you make too much money.
For tax purposes, any loan you acquire that is secured by your main home or your second home qualifies as a home equity loan. The Internal Revenue Service does not place any restrictions on how you use the proceeds. For example, if you borrow money using your main home as collateral and use the proceeds for a family vacation, the interest is deductible. If you use the proceeds to improve your home, such as adding on a garage, the interest is deductible under the higher mortgage interest limit rather than the home equity debt limit.
Generally, you're limited to deducting the interest on the first $100,000 of home equity debt each year. If your filing status is "married filing separately," each spouse can deduct the interest from up to $50,000. However, if you used the home equity loan proceeds to improve your home, you can use the mortgage interest limits, which allow you to deduct the interest on up to $1 million of debt, or $500,000 for each spouse if married filing separately.
Claiming the Deduction
At the end of the year, your lender sends you a Form 1098 that shows how much interest you paid on the loan during the year. To claim the deduction, report the amount of your home equity interest, plus any mortgage interest, on Line 10 of Schedule A. This amount, plus all of your other itemized deductions, is totaled on Line 29 of Schedule A, copied to Line 40 of Form 1040 and subtracted from your adjusted gross income.
Before you rush to apply for a home equity loan, remember that under the terms of this type of loan, you're putting your house on the line. If you default on the loan, you can lose your home. The other, less dangerous downside is that you can only deduct your home equity loan interest if you itemize your deductions. If your standard deduction is larger than your itemized deductions, you're better off not claiming your home equity loan interest before the standard deduction saves more money on your taxes.
- tax forms image by Chad McDermott from Fotolia.com